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The venture capital industry is about to enter a kind of mid-life crisis that could test its very foundations thanks to three key drivers:

1. Returns: For a long time, returns have the biggest selling point for venture capital as an asset class. Thanks to the collapse of the tech bubble in 2000 though, historical venture returns are guaranteed to take a huge dive south this year and to fall even further next year. That’s because 2010 marks the first year in which the 10 year track record of venture capital will not include returns from one of the late 1990’s “bubble years” and 10 year return records are one of the most common yard sticks investors use to judge asset classes. For example, taking the NVCA/Cambridge returns and indexing them produces a -31.2% decline from Q4 1999 to Q2 2009 (the last quarter for which data is available) and a whopping -43.6% decline from Q4 2000. Add to this the fact that venture returns did not peak until Q3 2000, and it’s basically a lock that by this time next year the 10-yr venture track record will actually be worse than the public stock market, probably by a signficant amount. Hard to sell “superior” returns at 2 and 20 when they are worse than a public index fund.

2. Liquidity: With 10-year fund lives and 5–6 year investment periods, venture has always been one of the least liquid asset classes. This lack of liquidity wasn’t a big issue when venture was generating attractive returns and LPs had most of their other assets in publicly traded bonds and equities, however two things have made liquidity a much bigger issue for the venture industry:

A. Over the past 10–20 years, many LPs have branched out into other illiquid asset classes such as private equity, resources, and land. B. The financial collaspe of 2008/2009 highlighted the potentially catastrophic consequences of illiquidity. Indeed, some of the least liquid LPs, such as major endownments, were forced to borrow money or accept huge secondary sale discounts just to raise short term cash. The long term consequnces of this near brush with disaster will be felt over time as many traditional venture LPs dial back their overall allocations to illiquid asset classes in general and demand higher returns from illiquid assets.

3.Correlation: All practicing VCs know that the Venture market is highly correlated to the public markets, but thanks to its early and, untill recently, uninterrupted success, the venture industry could credibly and mathematically maintain that there was relatively little correlation between venture returns and the public markets.

For example, from 1981 to 2009 there is just a 0.51 correlation between VC returns and the NASDAQ. In the 1980’s this correlation was actually less than that at 0.48. Over time though, the venture market has become more correlated with the public market. For example, the 5 year trailing correlation between VC returns and the NASDAQ was 0.69 as of Q2 2009. What’s more, with the imposition of the FAS 157 accounting standard this correlation is almost guaranteed to increase thanks to the fact that most auditors now use public benchmarks to help establish the “fair value” of venture investments.

It is correlation and not returns which is actually the single most dangerous issue facing the venture industry. Why? Because most LPs use modern portfolio theory and that theory holds, generally speaking, that if you add attractive, non-correlated assets to a portfolio you will increase returns while reducing risk. This investment paradigm is the saving grace of venture capital because it basically compels LPs to add exposure to the venture “asset class”.

However, if the venture and public markets become strongly and consistently correlated, venture may very well cease to become a separate asset class from an investment perspective and thus effectively kill off a huge portion of LP demand for venture capital exposure. The net effect of these three factors is that, from the perspective of a limited partner, venture is increasinsly looking like a highly illiquid, poorly performing, levered bet on the public markets. This is not a recipe for industry success and indeed almost dictates that the size of the venture industry is likely to at least stagnate and probably fall significantly over the next 5 to 10 years.

What Can Be Done?

Unfortnately, there’s no magic cure for these ills. Most VCs I talk with say something along the lines of “if only all those other idiots would stop investing, things would be fine” which is another way of saying that if less capital was raised and invested overall, returns would recover. While it is true that less overall capital would likely raise returns somewhat, the venture industry has now matured, in terms of capital and information flows, to the point where returns will likely never revert to their early averages, but to a risk adjusted return that is roughly comparable to the overall market.

As for correlation, venture is what it is. Fundamentally, venture will always be correlated with the equity markets because VC funds are really just long only micro-cap funds. FAS 157 just drives that reality home.

That leaves liquidity which is one of the areas that VCs can and probably should take a long hard look at because it’s the one driver that they have a degree of direct control over. While there is a secondary market for VC interests it is very ineffecient by most measures.

This is partially due to the nature of the assets being traded, but also due to the legal structures of VC funds themselves. Changes to the structure and rules governing VC partnerships as well as the establishment of industry-sponsored secondary market mechanisms could greatly improve liquidity thereby making venture a more competitive asset class. Without such changes, the venture industry risks a more severe contraction than what already looks likely.